Gold Investor

8/22/2019 Gold Investor

1/36

Gold Investor

Risk management and capital preservation

In this edition:

GoldandUSinterestrates:

A reality check

Whatdrivesgold?

Theroleofgoldin

defined-contributionplans:

Mexicocasestudy

Volume 3, July 2013


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About the World Gold Council

The World Gold Council is the market development organisation

or the gold industry. Working within the investment, jewellery

and technology sectors, as well as engaging with governments

and central banks, our purpose is to provide industry leadership,

whilst stimulating and sustaining demand or gold.

We develop gold-backed solutions, services and markets based

on true market insight. As a result we create structural shits in

demand or gold across key market sectors.

We provide insights into international gold markets, helping

people to better understand the wealth preservation qualities o

gold and its role in meeting the social and environmental needs

o society.

Based in the UK, with operations in India, the Far East, Europe

and the US, the World Gold Council is an association whose

members comprise the worlds leading gold mining companies.

For more information

Please contact Investment Research:

Juan Carlos Artigas

[email protected]

+1 212 317 3826

Johan Palmberg

[email protected]

+44 20 7826 4773

Boris Senderovich

[email protected]

+1 212 317 3882

Marcus Grubb

Managing Director, Investment

[email protected]

+44 20 7826 4724

Scan with your mobile device to

access our research app or investors

Gold Investor | Risk management and capital preservation


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Contents

Foreword 02

I: Gold and US interest rates: a reality check 03

What can be inerred rom golds relationship to

US real rates? 05

The established view and that well-worn chart 06

The undamental picture o the gold market 07

How do real rates impact golds portolio attributes? 08

Returns 08

Volatility 10

Correlation 10

Has the relationship with real interest rates changed

over time? 12

Conclusion 13

Reerences 14

II: What drives gold?

Factors that inuence gold and its role in a portolio 15

Common misconceptions about gold 16

Key themes that help explain golds perormance 17

Golds role in a portolio 19

Conclusion 19

Bibliography 20

III: The role o gold in defned-contribution plans:

Mexico case study 21

From defned benefts to defned contributions 22

The Mexican pension und experience 23

The structure o the typical Mexican pension portolio 23

Golds role in Mexican defned-contribution portolios 24

Focus 1: The case or gold as a strategic asset 25

What can gold do or the average Mexican

retirement portolio? 26

Finding golds optimal allocations 27

Optimal allocations based on historical returns 28

Focus 2: Using gold denominated in US dollars

(currency-hedged exposure) 29

Perormance during tail-risk events 30Optimal allocations based on expected returns 30

Conclusion 31

Reerences 32

01


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Foreword

Welcome to the third edition o Gold Investor. We are pleased to share a selection o the latest

research rom the World Gold Council.

The rst hal o this year proved a tumultuous one or the gold market. Sustained downwardpressure on the gold price ollowing Aprils exceptional pullback created two distinct trends:

some investors and speculators took the drop in price as a sign that golds bull run was probably

over; other investors and consumers saw an opportunity to buy jewellery and add gold to their

portolios. Gold-backed ETFs experienced substantial redemptions, but at the same time bar and

coin demand in Asian markets as well as in many parts o the Western world surged.

The dichotomy seen in the responses o market participants highlights golds varied consumer and

investor base, which in turn points out golds role as a portolio diversier. In act, the strategic

case or owning gold is still very much in place, and given its price pullback, investors can take

advantage o the portolio benets gold brings at a lower cost. Gold helps investors preserve

capital and manage portolio risk more eectively. It increases portolio diversication through

its lower correlation to other assets; reduces portolio losses during tail-risk events; adds a high

quality, liquid asset; hedges against both high infation and defation; and hedges against currency

risk and loss o purchasing power.

In this edition o Gold Investor, we rst explore the ot-cited relationship between gold and real

interest rates inGold and US interest rates: a reality check. Common wisdom suggests that

rising interest rates diminish the benets o gold a reason used by some investors to reduce

their gold exposure earlier in the year. Our analysis nds, however, that while negative real rates

have indeed coincided with periods o higher gold returns, a moderate interest rate environment

(with real rates ranging between 0% and 4%) is not necessarily adverse or gold and that golds

portolio benets are maintained. Next, in What drives gold?, we discuss the main actors that

infuence gold and provide investors with a broad ramework to analyse its perormance. Finally,

in The role o gold in dened-contribution plans, we discuss the role gold plays in helping investors

achieve their retirement goals, using Mexicos dened-contribution pension system as an

example. This article nds that modest allocations to gold ranging rom 1% to 7%, depending on

market perormance expectations and portolio composition can signicantly reduce risk without

diminishing returns.

I hope you nd this edition o Gold Investorinormative and stimulating, and I welcome

your views. To access the ull suite o World Gold Council research, please visit www.gold.org

Marcus Grubb

Managing Director, Investment

http://www.gold.org/download/rs_archive/Gold_as_a_Strategic_Asset.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/gold_investor/2013-04/gold-investor-201304.pdfhttp://www.gold.org/download/gold_investor/2013-04/gold-investor-201304.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/Gold_as_a_Strategic_Asset.pdf


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I: Gold and US interest rates:a reality check

AstheUSeconomystartstoshowsignsofrebalancing,

pavingthewayformonetarypolicynormalisation,weexplore the misconceptions surrounding the relationship

goldhaswithrealinterestrates.Wedemonstratethathigherrealratesarenotunconditionallyadverseforgold,astheeectofotherfactorsneedstobeconsidered.Thus,goldsportfolioattributesarenotcompromisedbyareturntoanormalinterestrateenvironment.Inaddition,wend

theinuenceUSrealinterestrateshaveongoldhasrecededoverthelastfewdecadesasdemandhasshiftedfromWesttoEast.

Influenceon the price of gold

+

US Macro Economy

Global Markets / Economy

$ %

02_03


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Over the last ew years, in the shadow o the nancial crisis, a crescendo o commentary

has preceded major central bank policy announcements. Positioning ahead o anticipated

quantitative easing programme launches or extensions was particularly everish, pushing

short-term US real rates close to -2%, a level not seen since the 1970s. Now the ocus has

shited to the potential end o these programmes. Though a normalised target interest rate

appears some time away, the longer end o the curve has shited in expectation o sustainable

economic growth, with 10-year nominal yields in the US leaping 85 basis points to 2.4%

between May and mid-June 2013. Talk o normalising interest rates has uelled uncomortable

oscillations in other asset prices.

The consequences o higher interest rates are many and bear both positive and negative

implications or investors, households, corporations and even governments. Yet, where

most market commentators appear to agree is the negative implication a rising interest rate

environment will have or gold. Why is this?

Theory will tell you that interest rates have a traditional relationship with gold through the channel

o rational investment decisions. In other words, investors measure the relative attractiveness o

gold by how much they can earn elsewhere. With gold viewed primarily as a currency and capitalpreservation asset but without a yield there is a cost to holding it i other assets yield more.

The relationship between gold and real rates is usually linked to US investment markets, but

commentators typically extrapolate implications to global gold buyers elsewhere. The basis or

the assumption that US interest rates orm a benchmark or global interest rates is rooted in the

ollowing reasons:

Gold is primarily traded in US dollars

The US dollar is the worlds reserve currency

US assets orm the lions share o the global investment portolio

However, gold is not only used or investment purposes in periods o low interest rates. It is also

a consumer product that can be positively infuenced by economic growth even i real rates are

rising. Further, a rise in US real rates has to be seen in the context o rates cycles in other partso the world, especially emerging markets. In act, as developing markets continue to expand, US

interest rates will likely become only one o many measures to gauge global opportunity costs.

Given the structural changes that gold has experienced or more than a decade, it is likely that

the US real interest rate will be less relevant than beore, particularly as demand increasingly

originates in emerging markets where domestic infation rates are more relevant than the US

infation rate.

The potential cessation o

QE has increased market

volatility.

A return to normal in the

US is consistently seen as

negative or gold

as it increases the

opportunity cost or

investors holding it.

Traditionally, US rates

have unctioned as a global

benchmark.

However, while investment

demand in Western markets

is important, it is just oneo the many variables that

inuence gold.



7/36

What can be inerred rom golds relationship to US real rates?

While returning to a more normal US interest rate environment should have implications or gold

investment especially in Western markets these may not be as negative as some market

commentators expect. In act, our analysis shows that golds attributes appear avourable in a

moderate real rate environment compared to either negative or high rate environments:

In a moderate rate environment (with real rates ranging between 0% and 4%), returns or gold

are in line with the long-term average o an annualised 6 7%.

Rising rates are worse or gold than alling rates, but still provide annualised returns well in

excess o a conservative 0% long-term infation-adjusted return estimate oten used to show

gold as a core portolio asset.

Golds volatility is signicantly lower in a moderate real rate environment. While rising real rates

are associated with increased volatility, it is only marginally higher than the long-run average.

The correlation between gold and global equities in a moderate real rate environment is close to

zero, which orms part o the basis or golds diversication properties.

High rate environments (with real rates exceeding 4%) are least avourable towards gold in

terms o returns, but volatility and correlations remain moderate relative to other assets.

Finally, a re-estimation o the gold price model developed or the World Gold Council by Oxord

Economics suggests that the gold price and US real rate relationship is weaker than in the past.

This is likely due to the eect o the increasing relevance o emerging market demand or gold and

consequently the infuence o their local macro-economic actors in determining its price.

Golds portolio attributes

would still be relevant in a

normal rate environment...

...especially as golds

relationship to US rates

has weakened over time.

04_05


8/36

The established view and that well-worn chart

Chart 1 shows one o the most common arguments with regard to holding (or selling) gold. It pits

the US real rate measured as the three-month T-bill interest rate less US headline CPI infation

versus the gold price in US dollars per troy ounce. Advocates o the strong relationship between

US real interest rates and gold point to the clustered shaded areas to the let and right, which

appear to have been almost unanimously associated with rising gold prices: the bull market o the

1970s and the bull market over the last twelve years, respectively. Accordingly, they will point to

the long all in the gold price rom its peak in the early 1980s through to 2001 and highlight that

this occurred during a positive and oten high real rate environment in the US and elsewhere.

It does suggest a compelling association.

A simple view suggests

a strong and consistent

negative link between

real US interest rates and

gold price.

But the chart does not show how dierent these two periods were:

High ination/low ination: The low to negative real rates during the 1970s occurred amidst

very high and rising infation, while the low real rates we have mainly experienced during the

2000s (barring two episodes) have existed in a low nominal rate but low infation environment.

Strength o the US dollar: These two periods are also dened by very dierent US dollar

settings. The 1970s witnessed mixed ortunes or the US dollar but with an overall modest

decline. This is contrasted by the protracted decline in the US dollar over the last 10-plus years.

Gold demand and supply: The underlying supply and demand picture or gold has changed

signicantly. Today, emerging markets are key components in demand, and mine production is

almost evenly distributed throughout the dierent continents. Further, the period rom the early

1980s to the late 1990s was characterised by active central bank and producer-hedging activity.

Today, central banks are net buyers o gold and while producer hedging, a possible source o

supply, is at negligible levels.

Relative importance o US real rates: The advent o orward and utures markets during

the 1980s provided a new vehicle or participants in the gold market. Centred on LIBOR, a

US dollar-based benchmark or global interest rates, these market advances consequently

had a strong link to movements in physical gold and probably to prices as well.1 As developing

markets increase their importance in the global economy, the predominance o the US dollar

and its real rates will likely shit.

Yet not all real rate

environments are

created equal.

Chart 1: Gold is typically assumed to have a strong negative correlation to US real rates

US$/oz Real rate (%)

2,000 8

6

4

2

0

-2

-4

-6

-8

1,800

1,600

1,400

1,200

1,000

800

600

400

200

0

Reference notes are listed at the end of this article.

Source: Thomson Reuters Datastream, World Gold Council

l l l ll l l l

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

Real rate (rhs, 3m CPI) Negative real rate environment

Inflation adjusted gold price (in May 2013 US$/oz)

1 OCallaghan, Gary, The structure and operation o the world gold market, December 1991.

https://www.gold.org/download/pub_archive/pdf/The_evolving_structure_of_gold_demand_and_supply.pdfhttps://www.gold.org/download/pub_archive/pdf/The_evolving_structure_of_gold_demand_and_supply.pdf


9/36

The fundamental picture of the gold market

The supply and demand makeup o the gold market suggests that the relationship with US real

interest rates is less clear than common wisdom has it.

Firstly, the established view relates gold prices to movements in the real US interest rate through

investment channels. Over a ve-year average, global investment constitutes 27% o gold

demand (Chart 2a). Adding both exchange-traded unds (ETFs) and over-the-counter (OTC)

demand takes this share up to 37%, well below the 48% accounted or by jewellery demand.

Further, investment demand linked to the US and Europe only accounts or 18% o total

demand over the last ve years even i all OTC-related demand is assumed to originate here.

One thereore draws the conclusion that this is the exposure that most directly dictates the

negative relationship between the gold price and US interest rates. However, it is understood

that although constituting a small share o global demand (Chart 2b), the US and European

investor markets have a strong infuence on price oscillations simply because o the size o

their transactions, accessibility o their markets, and to some extent their infuence on investor

behaviour elsewhere. But that these two markets are the sole arbiters o gold prices is

questionable in the medium- to long-term.

Investment demand linked

to the US market is one o

many actors that inuence

gold. Thus, why should US

real rates be assumed so

inuential?

Chart 2: (a) Jewellery and technological applications make up more than

50% of demand, while (b) most gold is bought in emerging markets

l l


Source: Thomson Reuters GFMS, World Gold Council

Europe 17%

North America 11%

Middle East 11%

Indian sub-continent 25%

East Asia 30%

CIS 2%

Latin America 1%

Africa 1%

Other 1%

Jewellery 48%

Investment 27%

Technology 11%

Central banks 4%

ETFs and OTC 10%

06_07


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Table 1: Golds return is higher under low and moderate real rate regimes

Long term

Real rate level Real rate trend

Low

(4%) Falling Rising

Average monthly return 0.6% 1.5% 0.7% -1.0% 0.8% 0.3%

Standard error 0.3% 0.5% 0.4% 0.6% 0.3% 0.4%

Statistically dierent

rom zero No Yes No No Yes No


rom long term? - No No Yes No No

Reerence notes are listed at the end o this article.

Source: Bloomberg, World Gold Council

2 A simple approach is adopted here primarily to maintain consistency with perceived wisdom. Thus, the real rate we use to represent both rational and

actual expectations is a straight average o two o the simplest: the US CPI infation and the established Michigan survey o infation expectationscovering the outlook one year ahead. Our numerator is a one year continuous Treasury bond yield.

3 These boundaries are a logical and symmetrical extension o the neutral real interest rate (estimated at 2.25% in 2005), which is the rate at which

output growth matches its potential.

4 Other requencies and longer/shorter windows did not materially aect the results.

Secondly, how do the other categories o demand respond to interest rates? The historical

sensitivity o jewellery demand to gold prices would, by extension, mean that jewellery demand

is positively correlated to interest rates (i the rate/price relationship holds). Thereore, lower

prices would stimulate gold jewellery buying. In some corners o the world this does not hold,

particularly in emerging markets where buying is a consistent eature o landscapes that include

cultural incentives to buy gold. In India or example, the motives or investment and jewellery

buying are not mutually exclusive, and real rate sensitivity is unclear. An econometric analysis

o gold demand in India by Dr. R Kannan ound that the domestic real deposit rate had no

statistically signicant eect on gold demand. Rural consumers, lacking access to nancial

services and having a strong preerence or the physical were seemingly indierent to real

interest rates.

The pro-cyclical nature o technology demand also tends to be positively correlated to real interest

rates. Higher or rising domestic real rates are oten consistent with improving economic health,

which spurs the demand or gold in industrial and technological applications.

Finally, while prior to the global nancial crisis central banks had mandates more closely tied to a

search or yield, the events o 2007 2008 propelled risk mitigation to the core o most centralbank reserve management strategies. As such, risk management takes precedence over yield,

and the response by central banks to higher interest rates is likely to be undamentally dierent

rom that o investors.

How do real rates impact golds portfolio attributes?

While real interest rates are one o the actors that infuence gold prices, the core value o gold

to an investor lies in its contribution to portolio perormance via the attributes that make gold a

oundation portolio asset. Using a simple regression analysis with dummy variables representing

dierent rate environments, we explore how golds attributes have ared historically. These real

rate environments are dened as ollows:2 high (>4%), moderate (0%-4%) and low (


11/36

The results eectively exhibit average returns or the various rate environments.5 Golds average

monthly return since 1975 is 0.6%, translating to an annualised 7.5% nominal return.6 The best

returns have been achieved during low real rate environments (1.5% monthly). During moderate

real rate environments golds monthly rate o return is 0.7%, largely in line with the long-term

average. High real rates, as might be expected, are associated with lower monthly average

returns o -1%. The average returns suggest, as common wisdom has it, that real rate regimes

are negatively correlated to returns. However, average returns during the various environments

analysed are mostly not statistically dierent rom the long-run average and, other than returns

during low interest rate environments, they are not statistically dierent rom zero.7

Ater looking at the level o real rates, let us consider their trajectories. Chart 3 below details the

trajectory o gold during high US real rate environments. There is by no means a clear-cut pattern

in behaviour. Gold ell during the mid and late 1980s (2nd and 4th boxes in the chart), but showed

resilience in the early part o the decade and even rose during the 1985 to 1987 period. This

unexpected behaviour suggests that other macro-economic or undamental actors are dominant.

For example, previous research has also ound it dicult to disentangle the eects o real rates on

gold rom those stemming rom changes in the US dollar and infation.8

In addition, returns

during moderate rate

environments are in line

with golds long-term

average.

While high real rates have

historically coincided with

lower gold returns, their

eect may be overcome by

changes in the US dollar or

ination expectations.

As Table 1 shows, rising real interest rate environments have lower (yet positive) returns or gold

than do alling ones, with 0.3% average returns versus 0.8% or alling rate environments. While

the low returns or the rising environment may not thrill those who opportunistically hold goldor capital gains, they do, however, support golds portolio attributes. Indeed, the bulk o lower

returns come rom high and rising rate environments. By contrast, the period between October

2003 and October 2006 saw US real rates rise rom low levels negative 1% to almost 3%

yet gold had a cumulative return close to 60% over the period.

Rising real rate

environments are only

marginally worse orgold than alling ones.

Chart 3: Golds relationship with real rates is less clear when viewed in the context of

other fundamental factors (100 = 01/1978)

Index level

500

450

400

350

300

250

200

150

100

50

0



l l l l l l l ll

l ll l l l l l

1978 1979 1980 1981 1982 1983 19851984 1986 1987 1988 1989 1990

High real rates Equities Gold Dollar

5 These results do not suggest any causal link and do not control or other actors.

6 Returns are calculated using an arithmetic average.

7 As a rough rule o thumb, estimates are considered signicantly dierent in statistical terms only i they are more than two standard deviations away

rom each other.

8 Sherman, Eugene J., A gold pricing model, The Journal o Portolio Management, Spring 1983.

08_09


12/36

Table 2: Golds volatility is lowest in a moderate real rate regime

Long term


Low

(4%) Falling Rising

Annnualised volatility 17.3% 20.5% 14.1% 21.2% 17.2% 17.6%

Standard error 1.0% 2.1% 1.0% 2.7% 2.6% 3.3%


rom long term? - Yes Yes No No No



Volatility

Return is not the only variable that matters to investors. Understanding risk is particularly

important in portolio management. Thus, we examined how golds volatility has behaved during

the three real interest rate regimes. Results suggest that volatility is signicantly infuenced by the

prevailing real rates regime (Table 2).

Gold volatility is

signifcantly inuenced by

the real rate environment.

The long-term average or the sample is 17.3%. In act, gold has exhibited lower volatility during

moderate real rate environments. Both high and low rate environments have shown consistently

higher volatility at 21.2% and 20.5%, respectively, a likely cause being that both these

environments are associated with higher market uncertainty (as seen during the last ew years)

or high infation (as experienced in the late 1970s). However, the volatility estimate or the high

interest rate environment is not statistically dierent rom golds long-term volatility. Additionally,

golds volatility has displayed almost no dierence during alling or rising rate environments. It

appears that the level o rates is more strongly associated with golds volatility than the direction

o the moves. This makes sense as the direction o interest rates is unlikely to infuence asset

volatilities unless the movement is unexpected, ast or sizeable.Correlation

The nal characteristic to consider is correlation. Golds unique correlation behaviour has been

documented at length in our research. But ew correlations are constant over time. Are changes

in correlation systematic or random? In other words, are there regimes during which golds

correlation is systematically dierent rom its long-run average? We have noted previously that

golds correlation with equities is generally asymmetrical: alling equities oten lead to a negative

correlation with gold, whereas rising equities are oten associated with a zero or slightly

positive correlation.

At rst glance, there seems to be no consistent pattern in terms o correlation between gold and

risk assets during dierent interest rate scenarios. However, one might expect some convergence

in shorter-term returns between riskier assets as uncertainty prevails and a reduced number o

actors drives asset returns. This is something we have seen during various periods over the last

ew decades (Chart 4).

Moderate real rate

environments lower

volatility on average by

6 to 7 percentage points

compared to high or low

environments.

Golds correlation

profle with risky assets

in particular equities

changes over time

tending to increase when

rates are high.

http://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/investment/research/regular_reports/gold_investor/


13/36

Table 3: Golds correlation to equities is lowest in a moderate real rate regime

Long term


Low

(4%) Falling Rising

Correlation 0.03 0.08 -0.06 0.20 0.00 0.09

Standard error 0.04 0.05 0.04 0.06 0.05 0.07


rom long term? - No Yes Yes No No



Chart 4: The relationship between golds correlation to equities and real rate regimes

is less obvious

Real rate (%) Correlation1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

10

8

6

4

2

0

-2

-4

-6


Source: Thomson Reuters Datastream, World Gold Council

l l ll l l l l l l

l ll l l l l l

1975 1980 1985 1990 1995 2000 2005 2010

Real rate (%) Centred moving average Equity/gold correlation

Table 3 details the results or correlations between gold and global equities during the three real

rate environments.9 For a moderate environment, correlations are very close to zero and slightly on

the negative side, close to the sample average o 0.03. This long-term correlation is a key driver o

golds diversication benets. During moderate real rate environments, gold has even exhibited a

slightly negative correlation. High real rate environments, however, suggest that gold and equities

are more likely to move together. Why is this? While such an environment was prevalent only

during the 1980s, higher real interest rates can be negative or equities as well as gold stifing

investment and pushing down valuations via the discount rate. However, the US dollar appearsto have played a large part in this dynamic as high interest rates did not prevent gold and

equities rom rallying in tandem in the mid 1980s as the broad US dollar index ell. Further, an

average correlation o 0.2 is still low relative to the typical correlations ound between equities

and other assets.

A moderate regime is most

benefcial or the correlation

between gold and risk

assets, while correlations

increase during high rate

environments.

As discussed in previous sections, the relationship between gold and real interest rates is not

clear cut, even in an environment where the opportunity cost may seem prohibitive. A weaker

dollar may mitigate the negative eect o a rise in rates as it appeared to do in the late 1980s,

when the gold price almost doubled amidst periods o high real interest rates.

However, other actors,

such as the US dollar, can

inuence these correlations.

9 The global equity index assumes local currency returns to minimise the US dollar impact.

10_11


14/36

Has the relationship with real interest rates changed over time?

High US real rates do appear to apply the brakes to gold perormance. The last time such an

environment existed was in the early 1980s. Has the relationship between gold and real rates

changed since then? Given the aorementioned structural changes in the gold market in the last

two decades, it would be conceivable to believe that some o these established relationships

have shited.

To determine whether this might be the case, we re-estimated the robust gold price model

developed by Oxord Economics in 2011 over a contracting window, incrementally dropping older

data, quarter-by-quarter. The original models estimation period included the mid-1970s, so it

captured the dynamics in play at the time. In addition, we also re-estimated the parameters using

a 15-year moving window. The results are displayed in Charts 5a and 5b. The charts suggest that

ignoring the high real rate environment, which was prevalent in the late 1970s and early 1980s,

the US real rate variable has little meaning or gold prices.

O the macro-economic variables in Oxord Economics model, the US dollar has the most

persistent signicance as a consistently negative coecient, as the window is reduced to excludeolder data or moved along with a 15-year window. The most remarkable change is the drop in

the statistical signicance o the real rate, to close to zero i estimated rom the early 1980s until

today, and the eective disappearance o its economic impact. While the other variables show

shiting signicance, consistent with being important only during certain regimes, only the real

rate appears to have lost and not regained its signicance since 1981.

Previously, high real

rates have reduced golds

return, but the market has

experienced signifcant

changes.

Consequently, real rates

may now be less inuential.

In act, a closer inspection

reveals that the US dollarand other variables are

more relevant than

US interest rates.

T-stat T-stat

Chart 5: The influence of US real rates has receded over time, whether estimated by (a) removing past periods,(b) or using a moving window


Source: Oxford Economics, Thomson Reuters Datastream, World Gold Council

4

3

2

10

-1

-2

-3

-4

-5

-7

-6

Q376 Q379 Q382 Q385 Q388 Q391 Q394 Q397

5

4

3

21

0

-1

-2

-3

-4

-5

-6

Fed balance sheet Credit spreads US 5-year real rate US dollar index US CPI inflation

Q376 Q379 Q382 Q385 Q388 Q391 Q394 Q397

https://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttps://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdf


15/36

Conclusion

Real rates are an important consideration when constructing the ramework or understanding

movements in the gold price, but an awareness o when they are important is key. While the

relationship is logically and practically a driver o investment demand at times, it is only one o

several. In addition, investment demand is not the sole arbiter o gold prices, nor does it originate

solely in the US. Golds relationship with US real rates is not linear and is arguably changing.

As the dominant infuence o both the US economy and the US dollar slowly makes room or

emerging markets and their currencies, their macroeconomic actors will become structurally

more important in setting prices on the global stage, including that o gold.

Results rom our analysis show that contrary to the simplistic view that higher US real rates should

lead to lower gold prices, moving to a moderate real rate environment promotes golds portolio

characteristics urther. Returns in such an environment are in excess o the conservative return

estimate used to provide evidence o golds portolio contribution credentials. Volatilities all as

rates move into a moderate real rate environment, as do golds correlation with global equities.

While it is true that a high real rate environment has not been riendly to gold on average, the

underlying data is mixed and obscured by movements in other driving actors, such as the

US dollar. We do not know what a high real rate environment would mean or gold, as it would

be contingent on so many other actors, not least o which are those that now originate in

emerging markets. It is this last acet o the gold market that lends credence to the idea that the

infuence o the US real rate on gold has receded over the last couple o decades.

Golds relationship with

US real rates is not linear

and is changing.

A high US real rate

environment has not been

riendly to gold investment

demand, but other actors,

including the US dollar and

emerging market demand,

can wield signifcant

inuence.

12_13


16/36

References

Chart 1: Gold is typically assumed to have a strong negative correlation to US real rates

Real rate is computed as the dierence between the 3-month US Treasury bill yields less the headline US CPI

infation. Shaded areas denote negative real interest rate environments.

Chart 2: (a) Jewellery and technological applications make up more than 50% o demand, while (b) most

gold is bought in emerging markets

(a) The gures are computing using a trailing 5-year average o gold demand by sector.

(b) The gures are computing using a trailing 5-year average o gold demand by sector. CIS stands or

Commonwealth o Independent States or the ormer soviet republics. Total demand includes jewellery,

investment, technology and ETFs. Data assumes that the origin o buyer is the domicile o its abrication.

Table 1: Golds return is higher under low and moderate real rate regimes

Gold (US$/oz) returns are calculated on a monthly basis rom January 1975 to May 2013 as percentage changes.

Standard errors correspond to the (absolute) average o each regime: moderate, high or low and alling or rising.

Statistical signicance reported at the 5% level.

Chart 3: Golds relationship with real rates is less clear cut when viewed in the context o other

undamental actors

Equities are represented by the MSCI World index denominated in local cur rency. Gold is shown in US dollars.Trade-weighted US dollar basket is used to represent the dollar against other major currencies. Real rate is

computed as the 1-year Treasury bill yield less the average o headline US CPI infation and Michigan 1-year-ahead

infation expectations. High real rates are dened as greater than 4%.

Table 2: Golds volatility is lowest in a moderate real rate regime

The real rate is computed as it was in Table 1. Gold (US$/oz) volatility is calculated on a monthly basis rom January

1975 to May 2013. The value or each month is the annualised average o rolling 52-week volatilities or that month,

using weekly log returns. Standard errors correspond to the (absolute) average o each regime: moderate, high or

low and alling or rising. Statistical signicance reported at the 5% level.

Chart 4: Relationship between golds correlation to equities and real rate regimes is a bit less obvious

Correlation is represented by the monthly requency o 52-week rolling correlation between MSCI global equities in

local currency and gold (US$/oz). Real interest rate is computed as the dierence between the 1-year Treasury bill

yield less the average o headline US CPI infation and Michigan 1-year-ahead infation expectations.

Table 3: Golds correlation to equities is also lowest in a moderate real rate regime

The real rate is computed as it was in Table 1. Gold (US$/oz) and equity (MSCI world equity index in local currency)correlation is calculated on a monthly basis rom January 1975 to May 2013. The value or each month is the

average o rolling 52-week correlations or that month. Standard errors correspond to the (abso lute) average o each

regime: moderate, high or low and alling or rising. Statistical signicance reported at the 5% level.

Chart 5: The inuence o US real rates has receded over time, whether estimated by (a) removing past

periods, (b) or using a moving window

(a) The t-statistics were computed rom the equation that was published by Oxord Economics in the paper,

The eect o infation and defation on the case or gold, June 2011. That regression equation was re -run with a

contracting estimation window. The dates shown on the x-axis are the starting points o the regression which

goes to Q4 2010. What this char t shows is i the regression is run rom 1983 onwards, the eect o the US real

rate is negligible when seen in the context o the dollar, the Fed balance sheet, credit spreads and CPI infation.

(b) The t-statistics were computed rom the equation that was published by Oxord Economics in the paper,

The eect o infation and defation on the case or gold, June 2011. That regression equation was re -run with a

15 year moving estimation window. The dates shown on the x-axis are the starting points o the regression with

the ending date occurring 15 years ater the star ting date. What this chart shows is i the regression is run rom

1983 onwards, the eect o the US real rate is negligible when seen in the context o the dollar, the Fed balance

sheet, credit spreads and CPI infation.



17/36

Currencies

Inflation

Interest

rates

Consumerspending &

income

growth

Systemic &

tail risks

Short-term

investment

flows

Supply-side

drivers

II: What drives gold?Factorsthatinuencegoldanditsroleinaportfolio

Tosomeinvestors,goldseemsarcane:anon-productiveassetthatissimplyextractedandstored.Tomanyothers,goldplaysanimportantroleasastoreofwealthandportfolioriskmanagementvehicle.Tomost,akeychallengeisndinganappropriateframeworkofreference:whatgolddoes,whatitdoesnotdo,howandwhyitrespondstovariouseconomic

environments.Goldsperformancecanbeunderstoodinthecontextofsevenprimaryinterrelatedglobalthemes:itsrelationtocurrencies,globalinationandinterestrates,consumerspendingandincomegrowth,marketrisks,short-terminvestmentowsandsupply-relateddrivers.

14_15


18/36

When market commentators discuss gold, they typically use only one o a ew recurring actors in

evaluating golds price perormance. US-specic actors have historically received a preeminent

ocus. Such an approach, however, over-simplies and oten leaves investors under-inormed,

given golds global market and the numerous components that can aect its perormance in

dierent economic environments.

This does not mean that golds perormance is unexplainable or that golds investment

characteristics are dicult to understand. A comprehensive but simple ramework can provide

investors with a deeper understanding o this asset and ensures they have the appropriate

expectation or golds role in a portolio.

This research note seeks to outline a more comprehensive ramework or gold by discussing

various actors that infuence the gold market. Many o these actors can be categorised into

themes, which in turn infuence gold through one or more o the our sources o demand:

jewellery, technology, central banks and investment, or one o two sources o supply: recycled

gold and mine production.

This note is a segue to several research papers that explore the aorementioned themes, including

Gold and US rates: a reality check. While this brie note provides only an outline, when combined

with additional research it will provide investors with a comprehensive view o the asset including

the benets it brings to investment portolios.

Common misconceptions about gold

On various occasions during the past ew years, some market participants ocused on golds

increasing correlation to the stock market and alsely concluded that gold was becoming a risk

asset. However, as shown in our Q1 2012 Investment Commentary, in the context o a statistically

signicant variable like the US dollar, golds correlation to US equities became negligible.

Interpreting this correlation as a causal relationship could lead to a alse conclusion about golds

economic relationship to equities. Instead, it is prudent to view gold against all o its infuencing

actors simultaneously. Indeed, it is necessary to consider the bigger picture when evaluating a

particular variable.

Applying common valuation models used or other nancial assets to gold overlooks its unique

components. Typical discounted cash fow valuation models that apply to equities and xed

income do not adequately adapt to gold. In addition, the approach o evaluating commodities

on the basis o a supply and demand imbalance cannot readily be applied either because o its

large and available stock; a by-product o golds nonperishing qualities. An apparent lack o a

ramework or thinking about golds value and returns is a commonly cited barrier to investment.

Additionally, the analyst community tends to use solely US-specic economic variables to explain

changes in the gold price. This approach is overly limited, given the global nature o the gold

market. The US represented 10% o physical gold demand in 2012, while emerging markets

represented close to 70%. While the US represents a large portion o nancial markets and

US variables are indeed important in understanding macro-economic developments, exclusive

reliance on them to explain fuctuations in the gold price is inadequate.

Market commentators

tend to link gold to a ew

US-driven actors. Such an

approach alls short.

A comprehensive

ramework can help

investors become

comortable with gold.

Inuencing actors aect

gold through our channels

o demand and two

channels o supply.

Oten, spurious correlations

have led to erroneous

conclusions about the

relationship between gold

and equities.

Traditional rameworks

used or stocks and bonds

also prove inadequate.

The exclusive use o US-

driven actors is insufcient

to encapture golds global

dynamics increasingly

inuenced by emerging

markets.

http://www.gold.org/download/rs_archive/quarterly_statistics_commentary_q1_2012.pdfhttp://www.gold.org/download/rs_archive/quarterly_statistics_commentary_q1_2012.pdf


19/36

Key themes that help explain golds performance

In the ollowing section we discuss the general themes that infuence gold in order to help

investors develop a more comprehensive and accurate ramework. These themes should be

viewed as an interconnected set o actors. These themes include:

Currencies. Gold is oten thought o as a currency based on its widespread use as a store o

value and a unit o exchange. In 1971, the world adopted a foating currency regime, and gold

was no longer an ocial anchor o currencies. However, it retained some o its currency-related

attributes. In particular, its negative correlation to the US dollar and other developed market

currencies, as well as its use as a store o value in countries with volatile oreign exchange rates.

In contrast to at currencies, the quantity o available gold stocks cannot be expanded at will, thus

helping investors to protect against losses in purchasing power. See Gold and currencies: hedging

oreign-exchange riskand Gold and currencies: protecting purchasing power, included in previous

editions o Gold Investor.

Ination. Variables such as infation have a proound impact on how investors and consumers

view gold. Global infation and infation expectations dictate consumers purchasing power,driving the decisions o whether we buy something today or save it or tomorrow. High infation

is airly disruptive, and expectations o such an environment have a signicant infuence on golds

demand. However, golds hedging qualities need to be analysed in the context o global not

local infation. See The impact o infation in the case or goldand Gold and currencies: protecting

purchasing power.

Interest rates. Interest rates are a key component in the valuation o nancial assets because

they measure the opportunity cost o keeping money in cash (and high-quality short term bonds)

relative to any other asset. High interest rates can increase the opportunity cost o investing in

gold, but the economic environments in which they develop can also be supportive o gold as

a consumption good. However, global interest rates (not only US ones) ought to be taken into

consideration. See Gold and US rates: a reality check.

Consumer spending and income growth. Jewellery, bars, coins and technological applications

make up the majority o demand. Growth in disposable income and consumer spending promote

purchases o these goods. In particular, as emerging markets (which account or the largest share

o demand) expand urther economically, higher levels o wealth increase demand or gold.

In this research note we

outline the main themes

that inuence gold.

Gold has a negative relation

to the US dollar, a positive

relationship to the quantity

o money supply, and is

used as a diversifer or FX

reserves.

Gold is a global ination

hedge, and investorination expectations

inuence ows.

Interest rates aect

the opportunity cost o

investing.

Consumer spending and

income growth support

demand, as well as gold-

related savings.

16_17
https://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttps://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttps://www.gold.org/download/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/investment/research/regular_reports/gold_investor/https://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttps://www.gold.org/download/get/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/download/get/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/download/get/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/download/get/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttps://www.gold.org/investment/research/regular_reports/gold_investor/https://www.gold.org/download/gold_investor/2013-04/gold-investor-201304.pdfhttps://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttps://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdf


20/36

Systemic and tail risks. Systemic market disruptions and tail risks impact global markets and

have an infuence on gold as crises tend to drive fight to high-quality, liquid assets. These types

o events are dicult to predict but can have a devastating eect on investors wealth, typically

exacerbated by market momentum. Assets such as gold help to partly mitigate these losses.

See Gold: hedging against tail risk.

Short-term investment ows. There are incentives that propel short term investment fows,

including momentum and technical drivers that are not always correlated with undamental drivers

o demand and supply. Many investors wishing to make purchases based upon momentum or

technical indicators use the utures market because it is a liquid and highly marginable vehicle.1

This is a natural consequence o capital markets but also a source o liquidity and price discovery.

Supply-side drivers. The actors above look at the motivations or purchasing gold. The supply

o gold that is used to meet demand or these purchases is a actor that could potentially infuence

the gold price. All else being equal, a short term decline in mine production could induce physical

buyers to pay more or gold.

The aorementioned drivers have an infuence on gold and interact with each other through various

channels. For example, US interest rates and infation have a large impact on the attractiveness

o the US dollar. Interest rates and infation have an impact on consumer spending and miners

decisions to expand production. The appearance o systemic risks can lead investors to change

their risk management practices and allocate to diversiying assets like gold. These relationships

are just a ew examples that could potentially complicate investors attempts to use individual

variables when thinking about gold.

Furthermore, gold is a global asset, and the changing nature o the gold market means that a static

valuation ramework will not account or changes in the importance or the mutual interaction o

these variables.

Gold investment typically

increases during periods o

systemic and tail risks.

Investment ows driven by

momentum and technical

actors can aect gold

prices in the short run.

Supply rom mine

production and recycled

gold impacts its availability.

Taking a holistic approach

to gold is paramount, as

golds drivers respond

to various economic

environments

calling or a dynamic

ramework.

1 A highly marginable security is one that allows an initial payment that is substantially smaller than the value o the security. Margining leads to

increased leveraged which could ampliy losses and gains.

https://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttps://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdf


21/36

Golds role in a portfolio

As a by-product o the actors described above, gold has two primary unctions in investors

portolios:

Gold as a risk-management vehicle

Gold provides portolio diversifcation through its lower correlation to other assets. Golds

correlation to equities and bonds is, on average, 0.1 and, as discussed in Gold: a commodity like

no other, it has a correlation o 0.3 to the broader commodity complex.

Gold provides tail-risk protection by consistently reducing portolio losses during tail-risk

events as summarised in Gold: hedging against tail-risk.

Gold is a high quality, liquid asset. Gold traded an average o US$240bn per day in the rst

quarter o 2011,2 higher than most liquid equities, German Bunds, UK gilts, US agencies and

certain currency pairs (see Liquidity in the gold market). Gold lacks credit risk, helping investors

to balance the risks present in their xed income and equity allocations.

Gold as a source o capital preservation

Gold hedges against extreme ination scenarios like defation and hyperinfation. In the

paper The impact o infation and defation on the case or gold,Oxord Economics shows that

both environments lead to golds relative outperormance over other assets.

Gold protects against alls in developed market currencies. Gold has a -0.5 correlation

to the US dollar and a negative correlation against most other developed market currencies

(see Gold as a hedge against the US dollar).

Conclusion

Investors tend to analyse gold through the lens o a ew US-driven variables, typically in isolation.

This exercise is inadequate as it ails to consider all o golds infuencing actors as well as theglobal nature o the gold market and could lead to alse conclusions about golds investment

characteristics.

Instead, there are several globally interrelated actors that infuence the gold market, including:

currencies, interest rates, infation, consumer spending, systemic actors, short-term investment

fows, and supply-side drivers. Furthermore, the changing importance and mutual interactions

o these themes reinorce the need or a dynamic ramework in which to think about the gold

market. Such a ramework gives investors a tool to thoroughly analyse fuctuations in gold and

truly understand the source o golds portolio attributes: portolio risk management and capital

preservation.

As a result o those

actors, gold provides risk

management

and capital preservation to

investors.

Investors oten reduce

golds determinantsto a handul o US-led

variables...

yet golds drivers are

global and interconnected.

An understanding o these

dynamics is critical in

developing a ramework

or gold.

2 LBMA, Gold turnover survey or Q1 2011, August 2011.

18_19
http://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdfhttp://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/rs_archive/rs_30.pdfhttp://www.gold.org/download/rs_archive/rs_30.pdfhttp://www.gold.org/download/rs_archive/rs_30.pdfhttp://www.gold.org/download/rs_archive/rs_30.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdfhttp://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdf


22/36

Bibliography

Oxord Economics, The impact o infation and defation in the case or gold, July 2011.

New Frontier Advisors and World Gold Council, Gold as a strategic asset, July 2009.

World Gold Council, Gold and currencies: hedging oreign-exchange risk, Gold Investor, Volume 1, January 2013.

World Gold Council, Gold and currencies: protecting purchasing power, Gold Investor, Volume 2, April 2013.

World Gold Council, Gold: a commodity like no other, April 2011.

World Gold Council, Gold: hedging against tail risk, October 2010.

World Gold Council, Why is gold dierent rom other assets? An empirical investigation, March 2003.

http://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdfhttp://www.gold.org/download/pub_archive/pdf/Gold_as_a_strategic_asset_for_UK_investors.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/C_Lawrence.pdfhttp://www.gold.org/download/rs_archive/C_Lawrence.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/Gold_a_commodity_like_no_other.pdfhttp://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/download/gold_investor/2013-01/gold-investor-201301.pdfhttp://www.gold.org/download/pub_archive/pdf/Gold_as_a_strategic_asset_for_UK_investors.pdfhttp://www.gold.org/download/rs_archive/the_impact_of_inflation_and_deflation_on_the_case_for_gold.pdf


23/36

III: The role of gold indened-contribution plans:Mexico case study

Asmorepensionfundsaroundtheworldoptfordened-contributionstructuresandmoveawayfromdened-benetplans,contributorswillnotreceivethesameguaranteedpayoutsseeninthepast.Acomfortableretirementwillbebasedonthecombinationofcarefulplanningandathoughtfulinvestmentstrategy.Complementingabsolute

returnperformancewithcomprehensiveportfolioriskmanagementshouldbecomeaforemostpriority.Goldprovidesdiversicationandcapitalpreservationforinvestorswishingtoprotecttheirnestegg.

Cash

Bonds

Sto

cksP

ro

perty

20_21


24/36

There are a myriad o pension und structures and savings vehicles in various countries designed

to ensure that workers save sucient unds or their retirement. Retirement portolios are very

much goal-ocused, and contributors (uture retirees) look to achieve a target level o wealth that

is sucient to maintain a consistent standard o living during their retirement years. However,

these unds can also provide a source o unding during various lie events prior to retirement.

Thus, as market shocks can occur at any time, appropriate risk management is essential. In a

series o papers on golds role or retirement unds, we will ocus our attention on golds unction

as an integral part o strategies that help investors achieve their long-term goals.

This study explores the Mexican pension und experience and golds unction in retirement

portolios. Our analysis shows that gold can improve the risk/reward prole o investment

portolios where allocations to commodities are permitted. Adding a modest allocation to

gold (1% to 7% using historical asset perormance or 1% and 3% using conservative return

assumptions or gold) can reduce the volatility and Value-at-Risk (VaR)1 o a portolio while adding

liquidity, hedging against systemic risks, and helping to preserve wealth in the long term.

From dened benets to dened-contributions

Dened-benet plans, still prevalent around the world, typically oer a pre-negotiated percentage

o contributors salaries during retirement. As a result, portolio managers try to sustainably meet

the long-term liabilities associated with the plan. However, over the past two decades, there has

been a shit in the pension und space toward dened-contribution systems.2 Here, employers

typically contribute a pre-determined amount (or match some portion o the employees

contributions), but the unds available at the time o retirement are solely dictated by the

perormance o the investments whether the investment decisions are made by the contributors

themselves or by dedicated portolio managers.

While dened-contribution systems expose contributors to market risk (and potential rewards),

they are generally viewed as more ecient and sustainable rom an economic perspective. As

o 2012, 45% o pension und assets in the 13 largest markets were held in dened-contribution

plans, led by Australia, the US and the UK.3 In particular, in the US, 401(k) plans and IRA accounts

held US$ 9.9tn (58% o the market) by the end o 2012, comortably surpassing assets managed

by traditional dened benet plans.4

For retirement portolios,

risk management is key to

a successul investment

strategy.

Our analysis shows that

gold can reduce risk in

Mexican pension portolios

and help preserve wealth.

The retirement landscape

has been moving away rom

defned-beneft (DB) plans

to defned-contribution

plans (DC).

Around the world, DC

plans have been gaining

momentum.

1 The Value-at-Risk o a portolio measures the maximum loss an investor can expect with a certain degree o condence during a dened period

o time. More ormally, the VaR o a portolio at given condence level (1a) is the maximum expected loss such that the probability that any

other loss exceeds that value is no greater than a or a dened period o time.

2 Towers Watson, Global pension assets study 2013, January 2013.

3 Ibid.

4 Ibid.



25/36

The Mexican pension fund experience

Mexico has a airly well developed nancial market or a country that is typically classied as an

emerging economy. It has a ully convertible currency and liquid capital markets. It has a wide

array o nancial products that includes cash (Cetes), longer-term government bonds (Bonos) ,

infation-linked bonds (Udibonos), and corporate bonds. Its equity market is one o the largest

amongst developing economies and is comparable to that o Singapore. Additionally, Mexican

investors can access international equities and bonds generally without capital restrictions.

Legislative changes that started during the 1990s led to the privatisation o the pension und

space. Contributors to the old dened-benet system were incentivised to migrate to the new

system. Newcomers were automatically enrolled. Thus, a system that by the end o 2012 held

approximately US$160bn (MXN$2tn) in assets under management has grown at a rate o

US$2.5bn (MXN$ 30bn) per month.

In the Mexican system, pension und managers (known as AFORES) are responsible or

investment decisions, but they need to ollow a comprehensive set o guidelines determined

by their regulatory agency (reerred to by its acronym CONSAR). These guidelines include thetypes o assets in which they can invest, rules on asset allocation, the amount o risk permitted

depending on the time to retirement, and the value-at-risk a portolio may experience. In early

2013, legislation was passed that allowed the use o gold and commodities in pension unds or all

but the oldest contributing age group.

The current pool o employees varies considerably in age, ranging rom younger participants

who have more than 40 years until their retirement phase to older participants who just have a

ew working years remaining. As this case study will show, gold has an integral role to play in

the portolios o young, middle-aged and older plan participants in the developing Mexican

pension market.

The structure o the typical Mexican pension portolio

Driven by the investment rules set by the CONSAR, the average dened-contribution pension

und portolio in Mexico has a relatively conservative allocation, where local government securities

allocation makes up 53.2% o assets, non-government xed income allocation makes up 23.4%

and an equities allocation accounts or 23.3%.5 Dened contribution providers in Mexico oer our

dierent portolio options (SIEFOREs), all o which vary in risk level linked to the age bracket o

the contributors. These are:

SIEFORE 4 or participants younger than 36

SIEFORE 3 or participants between 37 and 45

SIEFORE 2 or participants between 46 and 59

SIEFORE 1 or participants older than 60

Asset allocation varies signicantly within each age bracket (as we discuss later). Conventional

lie-cycle theory states that younger plan participants have a longer period o time until retirement

and consequently have a greater amount o human capital, dened as the present value o uture

earnings. For most individuals, uture earnings are relatively certain and could be labelled a xed

income asset that will produce cash fows well into the uture. As a result o a longer time horizon

and larger human capital, younger participants should hold more equities in their portolio. Older

participants, on the other hand, have only a ew years to their retirement and dont have enough

time to recoup potential losses in equity markets. Their allocation tends to be more conservative

and concentrated in shorter term government bonds. SIEFORE 4 (younger participants) has the

highest risk tolerance, while SIEFORE 1 (older participants) has the lowest.

Mexico has a ully

convertible currency, liquid

capital markets and an

equity market comparable

to Singapores.

Legislative changes led to a

large scale move towards

DC plans

where DC investments

are not sel directed but

administered by undmanagers (AFORES).

Gold has a role to play in

the portolios o young and

older participants.

The average Mexican

pension portolio is

allocated in a conservative

manner.

AFORES have our dierent

portolios (SIEFORES),

which they manage or plan

participants ranging romlow risk to higher risk.

5 J.P. Morgan, Mexico: Pension unds monitor, May 2013.

22_23


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Regulations set orth by the CONSAR help ensure that each pension manager selects an asset

allocation that is appropriate or the plan participants. Table 1 outlines the constraints that

portolio managers need to ollow or each SIEFORE. The maximum equity allocation allowed

reduces with age, and so does the one or commodities. The maximum commodities allocation

(including gold ) is 10% or SIEFOREs 4 and 3 but only 5% or SIEFORE 2 and 0% or SIEFORE 1.

SIEFOREs ollow a set

o constraints set by

the regulator to ensure

appropriate risk and

concentrations levels.

Golds role in Mexican dened-contribution portfolios

To assess the eect that gold has in Mexican pension und portolios, we rst looked at past

perormance (in Mexican peso terms) o typical assets held within retirement portolios.6 As part

o the wave o growth in emerging markets, Mexican equities and bonds have perormed airly

well over the past decade. Gold was also one o the best perorming assets, but in general mostasset classes, with the exception o the general commodity complex, had annual returns o more

than 5% per year (Chart 1a). At the same time, when seen in isolation, gold was also one o

the most volatile assets, although it was lower than that o a broader commodity basket, which

happened to be the most volatile asset in the group (Chart 1b).

Most assets, especially

gold, perormed well over

the December 2003

April 2013 period.

Table 1: Defned-contribution portolios are subject to multiple constraints set by the

regulator (CONSAR)

SIEFORE 4 3 2 1

Age category 60

Equities 40% 30% 25% 5%

Foreign currency 30% 30% 30% 30%

Foreign securities 20% 20% 20% 20%

Securities rom single issuer 5% 5% 5% 5%

Commodities 10% 10% 5% 0%

Infation bonds (Udibonos) - - - min 51%

Daily VaR (historical, 95%) 2.1% 1.4% 1.1% 0.7%

Maximum number o VaR breaches allowed 26 26 26 26

Source: CONSAR, J.P. Morgan

Chart 1: (a) Mexican equities and gold outperformed most asset classes in Mexican-peso terms, but (b) they alsohad higher volatility


Source: Barclays, Bloomberg, J.P. Morgan, LBMA, World Gold Council

Mexico sovereign (US$)

Global equities ex US

Mexico corporates

US corporates

US equities

US Treasuries

Mexico cash

Mexico equities

Gold (MXN/oz)

Mexico linkers (UDIBONOS)

Mexico sovereign (MXN)

Global treasuries ex US

Commodities

Nom. effective peso

US Treasuries


US corporates

US equities


Mexico corporates

Nominal effective peso

Commodities

Gold (MXN/oz)

Mexico equities


Mexico linkers (UDIBONOS)


Mexico cash

-5 0 5 10 15 20 25

Return (%) Volatility (%)

0 5 10 15 20 25

6 Due to data availability or xed income assets (which account or the lions share in pension und portolios) we used monthly data in the period

between December 2003 and April 2013 or this study.



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Correlations between gold and other portolio assets (denominated in Mexican pesos) are

relatively low, ranging rom -0.25 to 0.50 over the selected time period. Golds lack o correlation

to most portolio assets is particularly advantageous as it is the source o golds portolio

diversication benets (Chart 2).

Golds correlation to other

assets in the portolio are

relatively low, providing

portolio diversifcation.

Chart 2: Gold's correlation to other assets is typically low


Source: Barclays, Bloomberg, J.P. Morgan, World Gold Council

l l l ll

Mexico external Government debt

Mexico corporatesCommodities

Mexico equities

Cash (CETES)


Mexico local government debt


US Treasuries

US corporates

Linkers (UDIBONOS)

US equities

JPM Effective peso

-0.50 -0.25 0 0.25 0.50 0.75 1.00

Correlation

Focus 1: The case for gold as a strategic asset

In previous editions o Gold Investorand in other reports, the World Gold Council has

demonstrated golds integral role in investor portolios. The research has ound that optimal

allocations range rom 2% to 10% depending upon investor risk tolerance. Reports by J.P. Morgan,

Mercer and New Frontier Advisors show similar results with the consensus that gold should be a

oundation asset in investors portolios.7

In summary, the strategic case or gold is ounded on its ability to preserve long-term wealth and

manage risk eectively. As an infation and currency hedge, it helps to protect purchasing power.

Underpinned by its multiple sources o demand and supply (in terms o uses and geographic

distribution) which reduce golds correlation to most assets, gold acts as a portolio diversier.

As a store o wealth and driven by infows in times o systemic risk, gold helps reduce downside

risks during tail-risk events.Supported by a broad and global market, gold provides a healthy dose

o liquidity to a portolio, with the capacity to reducing credit and counterparty risk.

7 New Frontier Advisors, Gold as a strategic asset or European investors, December 2011.

24_25
http://www.gold.org/investment/research/regular_reports/gold_investor/http://www.gold.org/download/gold_investor/2013-01/hedging-foreign-exchange-risk.pdfhttp://www.gold.org/download/rs_archive/inv_gold_strategic.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/wgc_gold_as_strategic_asset_european_investors.pdfhttp://www.gold.org/download/rs_archive/wgc_gold_as_strategic_asset_european_investors.pdfhttp://www.gold.org/download/rs_archive/wgc_gold_as_strategic_asset_european_investors.pdfhttp://www.gold.org/download/rs_archive/wgc_gold_as_strategic_asset_european_investors.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/liquidity_in_the_global_gold_market.pdfhttp://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdfhttp://www.gold.org/download/rs_archive/inv_gold_strategic.pdfhttp://www.gold.org/download/gold_investor/2013-01/hedging-foreign-exchange-risk.pdfhttp://www.gold.org/investment/research/regular_reports/gold_investor/


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What can gold do or the average Mexican retirement portolio?

As an initial test o golds contribution to retirement portolios, gold was added to a generic

pension portolio with the other assets proportionally re-scaled to make room or a 5% gold

allocation, the middle point between 0% and the maximum allocation o 10% as dictated by

CONSAR. Due to data limitations, we had to estimate the asset allocation in relation to the indices

that were publicly available or analysis. Chart 3 details an approximation o the average pension

portolio. Table 2 shows the improvement in portolio perormance by adding a 5% allocation to

an average portolio over the December 2003 to April 2013 period. The portolio perormance

improved considerably as:

Portolio returns were improved by 28 basis points

Portolio volatility was reduced by 8 basis points

5% Value-at-Risk (VaR) was reduced by 2 basis points while maximum loss was

reduced by 43 basis points

Gold reduced the maximum and average portolio peak-to-trough drawdown

A 5% addition to the

average pension portolio

was able to improve

portolio returns and reduce

risk considerably.

Chart 3: The average Mexican pension

fund portfolio is fairly conservative


Source: J.P. Morgan, World Gold Council

l l l

MSCI Mexico 13%

MSCI US 7%MSCI AC World ex US 3%

US Treasuries 3%

US corporates 3%

Global treasuries ex US 2%

Mexico sovereign (US$) 8%

Mexico sovereign (MXN) 27%

Mexican corporates 10%

Mexican linkers 20%

Mexico cash 4%

Table 2: Gold improved risk-adjusted returns o the

average pension portolio

Gold (5%) Current allocation

Return 10.9% 10.6%

Volatility 5.09% 5.17%

Inormation ratio 2.15 2.06

5% VaR 1.59% 1.57%

Max Loss 3.31% 3.74%

Max pullback 7.11% 7.27%

Average pullback 0.62% 0.66%





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Finding golds optimal allocations

The results in the previous section were perormed using an average pension portolio. To make

the analysis more relevant, we looked at optimal allocations to gold using those same assets and

tested those or statistical signicance.

Both historical and expected return assumptions were used and contrasted or the purpose o

this optimisation (Table 3). Historical return assumptions were based on the perormance o

the assets using monthly returns between December 2003 and April 2013. The expected return

assumptions were the based on assets estimated uture returns. For example, or xed income

assets we use the yield-to-worst o the index. The expected return or all oreign currency

denominated assets is equal to the expected movement in the currency given the interest rate

dierential plus any other premium that is applicable to that asset. An additional premium was

included or all equity securities to refect the long-term equity premium over bonds.8 Expected

return assumptions are signicantly lower than historical return assumptions, partly refecting

lower interest rates but also relatively conservative return assumptions, especially or gold and

commodities. Volatility estimates were computed using historical monthly returns.9

Historical return

assumptions and expected

return assumptions were

used or the optimisation

study.

Table 3: Two scenarios under consideration: one using historical perormance and the other

based on market expectations

Real return and volatility assumption

Asset Historical Expected Volatility

Gold (MXN/oz) 12.0% 0.2% 19.5%

Commodities -0.8% 0.2% 21.1%

MSCI Mexico 15.0% 7.9% 18.1%

MSCI USA 3.2% 3.3% 10.2%

MSCI AC World 5.0% 2.6% 13.7%

US treasuries 2.2% -1.0% 12.8%US corporates 3.1% 0.8% 10.8%

Global treasuries ex US 1.8% -0.4% 11.8%

Mexico external government debt 5.2% 2.1% 10.4%

Mexico local government debt 6.0% 0.4% 5.8%

Mexico corporates 4.0% 2.9% 10.1%

Linkers (Udibonos) 6.7% 1.7% 7.1%

Cash (Cetes) 1.9% -0.6% 0.5%



8 The equity risk premium was sourced rom the Credit Suisse returns yearbook. Credit Suisse, Global investment returns yearbook 2013,February 2013.

9 Data limitations prevented us rom using longer data series as we have used in other studies. However, using a 10-year period span is consistent

with industry practices and may be a more robust approach when looking at emerging markets where currencies can have a big impact on volatilit y

estimates o oreign-denominated assets.

26_27


30/36

10 We used New Frontier Advisers patented portolio optimiser, which is based on a re-sampled eciency optimisation technique.

The Michaud Re-sampled Ecient Frontier has been acknowledged by Harry Markowitz, ounder o modern portolio theory, to be moreeective and robust than classical mean-variance optimisation.

11 A constraint on cash was added on the basis o typical pension holdings. While some AFORES oer cash alternatives, most unds dont

allocate more than 10% o assets to cash. Due to a limitation in the number o high quality o corporate debt, Mexican corporate bonds were

capped at a 10% weighting. In addition, the cap on individual issuer holdings translated into a 5% cap on US treasuries.

Optimal allocations based on historical returns

The rst set o optimisation returns used historical returns, volatility and correlation. The

ecient rontier was constructed using a re-sampled optimisation process based on historical

assumptions.10 Additionally, we included the investment constraints described in Table 1.11

The results were relatively consistent with previous ndings, even under the stringent criteria

set orth by the CONSAR. Chart 4a illustrates the optimisation results or each SIEFORE 2, 3

and 4. (Because SIEFORE 1 is not allowed to invest in commodities, we omitted those results.)

Portolios that included gold were selected on the basis o their Sharpe ratio and the portolios

resemblance to the typical portolio in its group. Portolios that excluded gold were selected to

match the return o the portolio containing gold to ensure a like to like comparison.

Optimal gold allocations or SIEFORE 4 and SIEFORE 3 were 7.3%, an impressive gure

considering that the total commodities constraint was 10%. For SIEFORE 2, the optimal gold

allocation was 3.9% compared with a commodity constraint o 5%. These results are airly

consistent with previous World Gold Council research, which ound that an allocation o between

2% 10% is optimal or most investors.

More importantly, optimal gold allocations had a proound impact on portolio perormance. In thecase o SIEFORE 4, or example, gold was able to reduce portolio volatility by 76 basis points

while maintaining the same levels o return (Chart 4b). Three-quarters o 1% or a US$1bn

portolio is equivalent to US$7.5mn in annual swings, a signicant gure by most standards.

Optmisation results using

historical returns are airly

consistent with previous

fndings: gold is able to

reduce volatility by 76 bps.

Chart 4: (a) Optimal portfolios contain a significant gold allocation, (b) as gold expands the efficient frontier

Gold (MXN/oz)

Global equities


Mexico cash

Commodities

US Treasuries


Mexico equities

US corporates

Mexico corporates

US equities


Mexico linkers



l

SIEFORE 4 SIEFORE 3 SIEFORE 2

Portfolio

Volatility (%)

0 4

10

20

30

40

50

60

70

80

90

100 10

9

8

7

6

5

Weight (%) Return (%)

Gold (5%) Gold (5%) Gold (5%)No gold No gold No gold 3 4 5 6 7 8 9

Gold reduced risk

by 76 basis points



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The historical perormance o the portolios that included gold compared well to their counterparts

without gold. Gold was able to reduce risk through lower volatility, lower Value-at-Risk (VaR) and

decrease peak-to-trough draw-downs (Table 4).

One o the other criteria set out by the CONSAR is the number o daily perormance breaches.

SIEFORE 4 has a perormance limit o -2.1%, SIEFORE 3 has a perormance limit o -1.4%,

and SIEFORE 2 has a limit o just -1.1%. CONSAR allows a maximum o 26 daily breaches.12

The portolio that contained gold was able to reduce the number o daily breaches or all

SIEFORE portolios.

Portolios containing gold

also help to reduce the

number o daily threshold

breaches set by the

CONSAR.

Table 4: Gold signifcantly reduced risk across all pension portolios where gold and

commodities are permitted

SIEFORE 4 SIEFORE 3 SIEFORE 2

Portolio results Gold (7%) No Gold Gold (7%) No Gold Gold (4%) No Gold

Return 13.28% 13.31% 12.50% 12.51% 11.90% 11.90%

Volatility 7.48% 8.57% 6.21% 7.09% 5.61% 6.13%

Inormation ratio 1.78 1.55 2.01 1.76 2.12 1.94

5% daily VaR 0.65% 0.75% 0.51% 0.61% 0.45% 0.51%

Daily VaR limit 2.10% 2.10% 1.40% 1.40% 1.10% 1.10%

Number o breaches 3 7 6 15 14 171% VaR 1.30% 1.60% 1.04% 1.25% 0.89% 1.02%

Average da

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